Here’s where investors are taking shelter from stock market turmoil and Fed hikes

‘The fact that you’re in the front-end of the yield curve means you either benefit from unrealized gains, or some higher reinvestment opportunities,’ says SVB’s Souza

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Taking shelter

By

SunnyOh

Investors are flocking to the short-end of the bond market as money managers declare it one of the safest spots to shelter from the Federal Reserve’s continued tightening of monetary policy and the jitters that have contributed to an October stock-market rout.

Bond fund managers, including the likes of Pimco and BlackRock, have urged turmoil-weary investors to seek shelter in short maturity bonds as higher interest rates push front-end yields to more attractive levels. That has helped dent the argument behind TINA—an acronym for the “there is no alternative”—the mantra that held that investors have few alternatives to stocks in a low interest rate universe.

Short-dated bonds are unlikely to match the returns of equities, but in a year where market turmoil has left few investments unscathed, it may end up as one of the few positive-yielding assets this year. Analysts say current yields for shorter maturity bonds leave them well-placed to protect investors from higher interest rates and stock market weakness.

“The fact that you’re in the front-end of the yield curve means you either benefit from unrealized gains, or some higher reinvestment opportunities,” said Eric Souza, senior portfolio manager at SVB Asset Management, who helps manage and invest the cash stockpiles of tech firms.

In essence, short-term bonds enable investors to benefit from higher and lower interest rates at current levels, he said. As part of a “ladder” strategy, investors can swiftly roll over the proceeds from maturing debt into similar bonds but with higher yields, juiced by rising interest rates. That gradually boosts the income earned from a portfolio of short-dated bonds.

The 2-year Treasury yield
TMUBMUSD02Y, -1.48%
trades at 2.831%, close to a 10-year high, according to Tradeweb. The short-dated maturity’s yield has doubled since last August after traders began to reckon with the Fed’s determination to raise rates in a steady but gradual manner.

BlackRock

U.S. short-term yields show appeal even on a historical basis

The growing calls to scoop up short-term government paper runs against the well-observed dynamic of short-term yields closely tracking expectations for the Fed’s hikes, which, in theory, leaves them poorly positioned for further monetary tightening. Bonds prices tend to weaken in a rising rate environment, as existing bonds are discounted to match the higher yields of newly issued debt.

But Rick Rieder, chief investment officer of global fixed income at BlackRock, said earlier this month the short-end had already priced in the impact of two to three additional rate increases next year.

Short-dated yields have overextended their climb, he said, insulating investors from expectations of further rate increases in the coming months. Thanks to their so-called carry, the income earned from holding on to bonds, a 2-year Treasury note can withstand a further yield increase of close to 1.4 percentage points without incurring a negative return over a one-year period, as of September, according to BlackRock’s calculations.

And for investors who seek a haven from volatility, front-end bonds have a strong record during stock market drawdowns. BlackRock’s analysis shows whenever the S&P 500 was down 5% over a six-month period, the 2-year note yield would fall on average 0.62 percentage point, much more than the 0.30 percentage point drop observed in the 10-year note.

Stocks have struggled in recent weeks as the Fed’s rate increases spark concerns over the sustainability of earnings growth in the coming quarters and a global economy losing steam, amid other worries. The S&P 500
SPX, +0.37%
is down nearly 10% from its all-time high set in late September, and the Dow Jones Industrial Average
DJIA, +0.42%
has shed more than 2000 points since the blue-chip benchmark established its record peak earlier this month.

Short-dated debt has started to attract not just professional investors, but households, too. Short-term interest rates are now lofty enough to lure households from checking accounts bearing zero deposit rates, wrote Torsten Slok, chief international economist at Deutsche Bank.

Meanwhile, managers of corporate cash hoards have also complained of the growing problems in sourcing bonds for their clients as other buyers wade into the market. Corporate treasuries tend to invest in short-term fixed-income assets as they can be swiftly sold without incurring hefty trading losses.

“It’s been difficult to find some of the short-end bonds we want. We’re getting a lot of nontraditional buyers,” said Souza.

This comes as flows into short-term bond exchange-traded funds have perked up. The iShares Short Treasury Bond ETF
SHV, +0.00%
has attracted more than $7 billion of inflows this year, while the SPDR Bloomberg Barclays 1-3 Month T-bill ETF
BIL, +0.02%
also drew $2.6 billion of inflows, FactSet data shows. Both are up more than 1% for the year.

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